8. Today, the one-year U. S. interest rate is 2%, while the one-year interest rate in Mexico is 8%. The spot rate of the Mexico peso (MXP) is $.06 The one-year forward rate of the MXP exhibits a 10% discount. Determine the yield (percentage return on investment) to an investor from Mexico who engages in covered interest arbitrage.

Solution:

Given,

1 Year U. S. interest rate = 2%

1 Year interest rate in Mexico = 8%

Rate of the Mexico peso = $0.06

MXP exhibits = 10% discount

Now,

The yield of an investor from Mexico who engages in protected interest arbitration (percentage return on investment):

(F - 0.06) / 0.06 = - 10%

F = $0.054 / MXP;

MXP1 x.$0.06 / MXP (1+2%) / $0.054 = MXP 1.1333

Yield of 13.33% > 8% in Mexico